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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**                                                                                                                                                                                                                                                                                  | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                   |
| **For  the quarterly period ended March 31, 2009**                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                   |
| **OR**                                                                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                   |
| **o**                                                                                                                                                                                                                                                                                  | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                   |
| **For the transition period from                   to                       ** |
|                                                                                                                                                                                                                                                                                   |
| **Commission  File Number  0-20191**                                                                                                                                                                                                                                              |

 

**INTRUSION INC.**

(Exact name of smallbusiness issuer as specified in its charter)

 

| **Delaware**                                                     | ** ** | **75-1911917**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**1101East Arapaho Road, Suite 200, Richardson, Texas 75081**

(Address of principalexecutive offices)

(Zip Code)

 

**(972)234-6400**

(Issuer’s telephonenumber, including area code)

 

**NotApplicable**

Former name, if changedsince last report)

 

* * * * * * * * * *

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days:   Yes xNo o

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (paragraph 232.405 of this chapter) during the preceding 12months (or for such shorter period that the registrant was required to submitand post such files).

Yes o No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 
| Large accelerated filer o                |   | Accelerated filer o         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                  |   | Smaller reporting company x |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o No x

 

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on April 30, 2009 was 11,638,405.

 

 

 

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**INTRUSIONINC.**

 

INDEX

 
| **PART I –  FINANCIAL INFORMATION**                                                                       | ** ** |   |
|---------------------------------------------------------------------------------------------------------------------|------------|--------|
|                                                                                                                |       |   |
| Item 1.  Financial Statements                                                                                  |       |   |
|                                                                                                                |       |   |
| Unaudited  Condensed Consolidated Balance Sheets as of March 31, 2009 and  December 31, 2008              |       |   |
|                                                                                                                |       |   |
| Unaudited  Condensed Consolidated Statements of Operations for the three months ended  March 31, 2009 and 2008 |       |   |
|                                                                                                                |       |   |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the three months ended  March 31, 2009 and 2008 |       |   |
|                                                                                                                |       |   |
| Notes to  Unaudited Condensed Consolidated Financial Statements                                                     |       |   |
|                                                                                                                |       |   |
| Item 2.  Management’s Discussion and Analysis of  Financial Condition and Results of Operations           |       |   |
|                                                                                                                |       |   |
| Item 4T.  Controls and Procedures                                                                              |       |   |
|                                                                                                                |       |   |
| **PART II – OTHER  INFORMATION**                                                                          | ** ** |   |
|                                                                                                                |       |   |
| Item 1.  Legal Proceedings                                                                                     |       |   |
|                                                                                                                |       |   |
| Item  1A.  Risk Factors                                                                                        |       |   |
|                                                                                                                |       |   |
| Item 3.  Defaults Upon Senior Securities                                                                       |       |   |
|                                                                                                                |       |   |
| Item  6.  Exhibits                                                                                             |       |   |
|                                                                                                                |       |   |
| Signature  Page                                                                                                     |       |   |

 

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**PART I— FINANCIAL INFORMATION**

 

Item 1. FINANCIALSTATEMENTS

 

**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except parvalue amounts)

 
| ** **                                                       | ** ** | **March ****31,********2009** | ** ** | **December ****31,  2008** | ** ** |
|------------------------------------------------------------------|------------|------------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                       | ** ** | ** **                         | ** ** | ** **                      | ** ** |
| Current Assets:                                                  |       |                               |       |                            |       |
| Cash and cash equivalents                                        |       | $                                  | 174        |                            | $          | 554 |   |
| Accounts receivable                                              |       | 200                                |       | 341                             |       |
| Inventories, net                                                 |       | 16                                 |       | 20                              |       |
| Prepaid expenses                                                 |       | 61                                 |       | 56                              |       |
| Total current assets                                             |       | 451                                |       | 971                             |       |
| Property and equipment, net                                      |       | 152                                |       | 169                             |       |
| Other assets                                                     |       | 39                                 |       | 39                              |       |
| TOTAL ASSETS                                                     |       | $                                  | 642        |                            | $          | 1,179 |   |
|                                                             |       |                               |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                  |       |                               |       |                            |       |
|                                                             |       |                               |       |                            |       |
| Current Liabilities:                                             |       |                               |       |                            |       |
| Accounts payable and accrued expenses                            |       | $                                  | 487        |                            | $          | 538 |   |
| Loan payable to officer                                          |       | 630                                |       | 480                             |       |
| Dividends payable                                                |       | 234                                |       | 187                             |       |
| Deferred revenue                                                 |       | 750                                |       | 1,090                           |       |
| Total current liabilities                                        |       | 2,101                              |       | 2,295                           |       |
|                                                             |       |                               |       |                            |       |
| Stockholders’ Deficit:                                      |       |                               |       |                            |       |
| Preferred stock, $0.01 par value: Authorized shares — 5,000 |       |                               |       |                            |       |
| Series 1 shares issued and outstanding — 260           |       |                               |       |                            |       |
| Liquidation preference of $1,396 as of March 31, 2009       |       | 918                                |       | 918                             |       |
| Series 2 shares issued and outstanding — 460           |       |                               |       |                            |       |
| Liquidation preference of $1,227 as of March 31, 2009       |       | 724                                |       | 724                             |       |
| Series 3 shares issued and outstanding — 354           |       |                               |       |                            |       |
| Liquidation preference of $824 as of March 31, 2009         |       | 504                                |       | 504                             |       |
| Common stock, $0.01 par value:                                   |       |                               |       |                            |       |
| Authorized shares — 80,000                                  |       |                               |       |                            |       |
| Issued shares — 11,648                                      |       |                               |       |                            |       |
| Outstanding shares — 11,638                                 |       | 116                                |       | 116                             |       |
| Common stock held in treasury, at cost — 10 shares          |       | (362                               | )          | (362                            | )          |
| Additional paid-in capital                                       |       | 55,422                             |       | 55,443                          |       |
| Accumulated deficit                                              |       | (58,602                            | )          | (58,280                         | )          |
| Accumulated other comprehensive loss                             |       | (179                               | )          | (179                            | )          |
| Total stockholders’ deficit                                 |       | (1,459                             | )          | (1,116                          | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                 |       | $                                  | 642        |                            | $          | 1,179 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS 

(In thousands, except pershare amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended**  | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                 | ** ** | **March 31, 2009** | ** ** | **March 31, 2008** | ** ** |
| Net product revenue                                                        |       | $                       | 761        |   | $ | 299 |   |
| Net customer support and maintenance revenue                               |       | 95                      |       | 163 |   |
| Total revenue                                                              |       | 856                     |       | 462 |   |
| Cost of product revenue                                                    |       | 271                     |       | 174 |   |
| Cost of customer support and maintenance revenue                           |       | 5                       |       | 5 |   |
| Total cost of revenue                                                      |       | 276                     |       | 179 |   |
|                                                                       |       |                    |       |   |   |
| Gross profit                                                               |       | 580                     |       | 283 |   |
|                                                                       |       |                    |       |   |   |
| Operating expenses:                                                        |       |                    |       |   |   |
| Sales and marketing                                                        |       | 264                     |       | 371 |   |
| Research and development                                                   |       | 366                     |       | 516 |   |
| General and administrative                                                 |       | 260                     |       | 265 |   |
|                                                                       |       |                    |       |   |   |
| Operating loss                                                             |       | (310                    | )          | (869 | ) |
|                                                                       |       |                    |       |   |   |
| Interest expense, net                                                      |       | (12                     | )          | (6 | ) |
|                                                                       |       |                    |       |   |   |
| Loss before income tax provision                                           |       | (322                    | )          | (875 | ) |
|                                                                       |       |                    |       |   |   |
| Income tax provision                                                       |       | —                  |       | — |   |
|                                                                       |       |                    |       |   |   |
| Net loss                                                                   |       | $                       | (322       | ) | $ | (875 | ) |
|                                                                       |       |                    |       |   |   |
| Preferred stock dividends accrued                                          |       | (40                     | )          | (40 | ) |
| Net loss attributable to common stockholders                               |       | $                       | (362       | ) | $ | (915 | ) |
|                                                                       |       |                    |       |   |   |
| Net loss per share attributable to common stockholders, basic and  diluted |       | $                       | (0.03      | ) | $ | (0.08 | ) |
|                                                                       |       |                    |       |   |   |
| Weighted average common shares outstanding, basic and diluted              |       | 11,638                  |       | 11,638 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

 
| ** **                                                                   | ** ** | **Three Months Ended**   | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                   | ** ** | **March 31,  2009** | ** ** | **March 31,  2008** | ** ** |
| Operating Activities:                                                        |       |                     |       |   |   |
| Net loss                                                                     |       | $                        | (322       | ) | $ | (875 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                     |       |   |   |
| Depreciation and amortization                                                |       | 17                       |       | 12 |   |
| Stock-based compensation                                                     |       | 17                       |       | 5 |   |
| Changes in operating assets and liabilities:                                 |       |                     |       |   |   |
| Accounts receivable                                                          |       | 141                      |       | (53 | ) |
| Inventories                                                                  |       | 4                        |       | 24 |   |
| Prepaid expenses and other assets                                            |       | (5                       | )          | 11 |   |
| Accounts payable and accrued expenses                                        |       | (42                      | )          | (33 | ) |
| Deferred revenue                                                             |       | (340                     | )          | 21 |   |
| Net cash used in operating activities                                        |       | (530                     | )          | (888 | ) |
| Financing Activities:                                                        |       |                     |       |   |   |
| Net activity under line of credit                                            |       | —                   |       | (86 | ) |
| Borrowings from officer                                                      |       | 150                      |       | 705 |   |
| Net cash provided by financing activities                                    |       | 150                      |       | 619 |   |
|                                                                         |       |                     |       |   |   |
| Net decrease in cash and cash equivalents                                    |       | (380                     | )          | (269 | ) |
| Cash and cash equivalents at beginning of period                             |       | 554                      |       | 362 |   |
| Cash and cash equivalents at end of period                                   |       | $                        | 174        |   | $ | 93 |   |
|                                                                         |       |                     |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                    |       |                     |       |   |   |
|                                                                         |       |                     |       |   |   |
| Preferred stock dividends accrued                                            |       | $                        | 40         |   | $ | 40 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Descriptionof Business

 

Wedevelop, market and support a family of entity identification, regulatedinformation compliance, data privacy protection, data leak prevention andnetwork intrusion prevention/detection products.  Our product families include:  TraceCopTM for identity discovery and disclosure,Compliance CommanderTM for regulatedinformation compliance and leak protection and data privacy protection, andIntrusion SecureNetTM for networkintrusion prevention and detection.  Ourproducts help protect critical information assets by quickly detecting,protecting, analyzing and reporting attacks or misuse of classified, privateand regulated information for government and enterprise networks.

 

OurTraceCop products include:  (1) databases containing IP addresses which are continually updated and used in thedetermination of the origination of cyber based attacks or other cyber basedcrimes; (2) analysis software used for the location of cyber based attacksand (3) data collected relative to the location of the crimes.

 

Wemarket and distribute our products through a direct sales force to end-users,distributors and system integrators, managed service providers and value-addedresellers. Our end-user customers include U.S. federal government entities,banks, credit unions, other financial institutions, foreign government entitiesand local government entities, hospitals and other healthcare providers, andacademic institutions.  Essentially, ourend-users can be defined as ‘any end-users requiring network security solutionsfor protecting their mission critical data’.

 

Wewere organized in Texas in September 1983 and reincorporated in Delawarein October 1995. For more than 15 years, we provided local areanetworking equipment and were known as Optical Data Systems or ODS Networks. OnApril 17, 2000, we announced plans to sell, or otherwise dispose of, ournetworking divisions, which included our Essential Communications division andour local area networking assets. On June 1, 2000, we changed our namefrom ODS Networks, Inc. to Intrusion.com, Inc., and our ticker symbolfrom ODSI to INTZ to reflect our focus on intrusion prevention and detectionsolutions, along with information compliance and data privacy protectionproducts. On November 1, 2001, we changed our name from Intrusion.com, Inc.to Intrusion Inc.

 

Ourprincipal executive offices are located at 1101 East Arapaho Road, Suite 200,Richardson, Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM and TraceCopTM aretrademarks of Intrusion Inc.

 

Asof March 31, 2009, we had cash and cash equivalents of approximately$174,000, down from approximately $554,000 as of December 31, 2008 and aworking capital deficit totaling $1.65 million. We used $530,000 of cash in operations in the first quarter 2009 andoperating cash outflows may continue in 2009. As of March 31, 2009, in addition to cash and cash equivalents of$174,000, we had $18 thousand in funding available under our $2.5 million lineof credit at Silicon Valley Bank, $70,000 available borrowings on our note fromG. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer, and $1.5million funding available from a written commitment to invest up to $1.5 million from G. WardPaxton.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have  sufficient cash resources to finance ouroperations and expected capital expenditures for the next twelve months. We expect to fund our operations through Company profits, our line ofcredit, borrowings from the Company’s CEO, and possibly additional investmentsof private equity and debt, which, if we are able to obtain, will have theeffect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

2.     Basis ofPresentation

 

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-Q and Item 10-01 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  The December 31, 2008 balance sheet wasderived from audited financial statements, but does not include all thedisclosures required by accounting principles generally accepted in the UnitedStates.  However, we believe that thedisclosures are adequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the three month period ending March 31, 2009 arenot necessarily indicative of the results that may be achieved for the fullfiscal year or for any future period. The unaudited condensed consolidated financial statements included 

 

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herein should be read in conjunction with theconsolidated financial statements and notes thereto included in our annualreport on Form 10-K for the year ended December 31, 2008, filed withthe commission on March 27, 2009.

 

3.     Inventories(In thousands)

 
| ** **                     | ** ** | **March 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                           |       |                     |       |                        |       |
| Inventories consist of:        |       |                     |       |                        |       |
|                           |       |                     |       |                        |       |
| Finished goods                 |       | $                        | 66         |                        | $          | 67 |   |
| Demonstration systems          |       | 2                        |       | 5                           |       |
| Reserve for obsolete inventory |       | (52                      | )          | (52                         | )          |
| Net inventory                  |       | $                        | 16         |                        | $          | 20 |   |

 

4.    Loan Payable to Officer

 

OnJanuary 30, 2008, we entered intoa revolving promissory note to borrow up to $700,000 from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.    Under the terms of the note, the Companymay borrow, repay and reborrow on the loan as needed up to an outstandingprincipal amount of $700,000 at any date. All outstanding principal and accrued but unpaid interest wereoriginally due on December 31, 2008 but were extended on March 19,2009 to mature on March 31, 2010. As of March 31, 2009 we had borrowings of $630,000 outstandingunder from the note with accrued interest payable of $7,000.  On March 20, 2008, we received a written commitment from our ChiefExecutive Officer to invest up to an additional $1,500,000 in the Company untilMarch 2009, should such funding be required by the Company.  This commitment to continue to advanceadditional funds as needed was extended on November 7, 2008 to mature in March 2010.  Amounts the Company borrowsunder the note and the commitment accrue interest at a floating rate per annumequal to the announced prime rate of Silicon Valley Bank (“SVB”) plus 1% andare unsecured.

 

5.     Line of Credit

 

On March 29, 2006,we entered into a Loan and Security Agreement (the “Loan Agreement”) withSilicon Valley Bank (“SVB”) to establish a $1.0 million line of credit with SVB(the “2006 Credit Line”).  On June 30,2008, we entered into an Amended and Restated Loan and Security Agreement (the “Amendedand Restated Loan Agreement”) with SVB to, among other things, replace the 2006Credit Line with a new $2.5 million line of credit (the “Current Line of Credit”).  Our obligations under the Amended andRestated Loan Agreement are secured by substantially all of our assets,including all of our intellectual property. Borrowings under the Current Line of Credit are based on advances (each,an “Advance”) against certain of our accounts receivable that are approved bySVB (each an “Eligible Account”).  SVBmay make an Advance of up to eighty percent (80%) of each Eligible Account, orsuch other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance chargecalculated as a daily rate that is based on a 360-day annual rate of (a) thegreater of the prime rate or 5.25%, plus (b) 1.5% or 2.0%, depending oncertain qualifying financial factors specified in the Amended and Restated LoanAgreement.  Finance charges are payableat the same time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.25% or 0.5% of all outstanding Advances, depending on certain qualifyingfinancial factors specified in the Amended and Restated Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Amended and Restated LoanAgreement, or (c) the date on which any “Adjustment” (as defined in theAmended and Restated Loan Agreement) is asserted to the Eligible Account.  On June 29, 2009, the Amended andRestated Loan Agreement terminates and all outstanding advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsbecome due under the Amended and Restated Loan Agreement and relateddocuments.  We have certain non-financialand financial covenants, including a liquidity coverage ratio and a rollingEBITDA computation, as defined in the Loan Agreement.  We have no borrowings outstanding under theCurrent Line of Credit as of March 31, 2009 and had borrowings availableof $18,000.

 

6.     Accountingfor Stock-Based Compensation

 

During the three monthperiods ended March 31, 2009 and 2008, the Company granted 476,000 and427,000, respectively, stock options to employees and directors.  The Company recognized $17,000 and $5,000,respectively, stock-based compensation expense for the three month periodsended March 31, 2009 and 2008.

 

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ValuationAssumptions

 

Thefair values of employee and director option awards were estimated at the dateof grant using a Black-Scholes option-pricing model with the following assumptions:

 
| ** **                             | ** ** | **For Three Months   Ended  March 31, 2009** | ** ** | **For Three Months  Ended  March 31, 2008** | ** ** |
|----------------------------------------|------------|---------------------------------------------------|------------|--------------------------------------------------|------------|
|                                   |       |                                              |       |                                             |       |
| Weighted average grant date fair value |       | $                                                 | 0.26       |                                             | $          | 0.17 |   |
| Weighted average assumptions used:     |       |                                              |       |                                             |       |
| Expected dividend yield                |       | 0.0                                               | %          | 0.0                                              | %          |
| Risk-free interest rate                |       | 1.9                                               | %          | 2.6                                              | %          |
| Expected volatility                    |       | 163.0                                             | %          | 107.0                                            | %          |
| Expected life (in years)               |       | 4.9                                               |       | 5.0                                              |       |
|                                        |            |                                                   |            |                                                  |            |  |  |

 

Expectedvolatility is based on historical volatility and in part on impliedvolatility.  The expected term considersthe contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward. Options granted to non-employees are valued using the fair market valueon each measurement date of the option.

 

7.     Net LossPer Share

 

Basic net loss per share is computed by dividing netloss attributable to common stockholders for the period by the weighted averagenumber of common shares outstanding for the period.  Diluted net loss per share is computed bydividing the net loss attributable to common stockholders by the weightedaverage number of common shares and dilutive common stock equivalents outstandingfor the period.  Our common stockequivalents include all common stock issuable upon conversion of preferredstock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the diluted loss per share calculation for the periodsended March 31, 2009 and 2008 are 4,058,737 and 4,248,628,respectively.  Our common stockequivalents are not included in the diluted loss per share for the three monthperiods ended March 31, 2009 and 2008, as they are antidilutive.

 

8.    Concentrations

 

Ouroperations are concentrated in one area—security software/entityidentification.  Sales to the U.S.Government through direct and indirect channels totaled 89.3% of total revenuesfor the first quarter of 2009 compared to 59.6% of total revenues the firstquarter of 2008.  During the firstquarter of 2009 approximately 84.3% of total revenues are attributable to twogovernment customers compared to approximately 56.6% of total revenuesattributable to two government customers in the first quarter of 2008.  There were no individual commercial customersin the first quarter of 2009 or 2008 that exceeded 10% of total revenues forthat quarter.  Our similar product andservice offerings are not viewed as individual segments, as our managementanalyzes the business as a whole and expenses are not allocated to each productoffering.

 

9.     Commitmentsand Contingencies

 

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows.  However, there can be noassurance such legal proceedings will not have a material impact.

 

10.  Dividends Payable

 

Duringthe quarter ended March 31, 2009, we accrued $16,000 in dividends to theholders of our 5% Preferred Stock, $14,000 in dividends to the holders of our Series 25% Preferred Stock and $10,000 in dividends to the holders of our Series 35% Preferred Stock.  As of March 31,2009, we have $234,000 in accrued and unpaid dividends included in othercurrent liabilities.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and did nothave sufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  Total penalties accruedduring the quarter ended March 31, 2009 were approximately $3,000.  Our CEO and one 

 

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memberof our Board of Directors, who own preferred stock, have waived the late feepenalty so we have recorded approximately $2,000 as contributed capital duringthe quarter related to these waivers.  Inaddition to this late penalty, the holders of our Series 2 Preferred Stockand Series 3 Preferred Stock could elect to present us with written noticeof our failure to pay dividends as scheduled, in which case we would have 45days to cure such a breach.  In the eventthat we failed to cure the breach, the holders of these shares of preferredstock would then have the right to require us to redeem their shares ofpreferred stock for a cash amount calculated in accordance with theirrespective certificates of designation. If we were required to redeem all shares of Series 2 PreferredStock and Series 3 Preferred Stock as of April 30, 2009, theaggregate redemption price we would owe would be $2.1 million.

 

Item 2.     MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward LookingStatements

 

This Quarterly Report on Form 10-Q,including, without limitation, the section entitled “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934 (The “Exchange Act”). Such forward-looking statements are generallyaccompanied by words such as “estimate,” “expect,” “believe,” “should,” “would,”“could,” “anticipate,” “may” or other words that convey uncertainty of futureevents or outcomes.  These statementsrelate to future events or to our future financial performance, and involveknown and unknown risks, uncertainties and other factors that may cause ouractual results, levels of activity, performance, or achievements to bematerially different from any future results, levels of activity, performanceor achievements expressed or implied by these forward-looking statements.Factors that may cause actual results to differ materially from currentexpectations, which we describe in more detail elsewhere in this QuarterlyReport on Form 10-Q  under theheading “Factors That May Affect Future Results of Operations,” and in our2008 Annual Report on Form 10-K in “Item 1 — Description of Business”include, but are not limited to:

 
| · | insufficient  cash to operate our business and inability to meet our liquidity  requirements;                                                                                                                                |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                         |
| · | loss of revenues  due to the failure of our newer products to achieve market acceptance;                                                                                                                                     |
|   |                                                                                                                                                                                                                         |
| · | our need to  continue current revenues levels in order to sustain profitability;                                                                                                                                             |
|   |                                                                                                                                                                                                                         |
| · | concentration of  our revenues from U.S. government entities and the possibility of loss of one  of these customers and the unique risks associated with government customers;                                               |
|   |                                                                                                                                                                                                                         |
| · | our dependence  on sales made through indirect channels;                                                                                                                                                                     |
|   |                                                                                                                                                                                                                         |
| · | the challenge of  selling our products internationally;                                                                                                                                                                      |
|   |                                                                                                                                                                                                                         |
| · | our dependence  on equity or debt financing provided primarily by our Chief Executive Officer  in order to meet our cash flow requirements;                                                                                  |
|   |                                                                                                                                                                                                                         |
| · | the effect that  payment of accrued dividends on our preferred stock has on our cash resources  and the substantial dilution upon the conversion or redemption of our  preferred stock and exercise of outstanding warrants; |
|   |                                                                                                                                                                                                                         |
| · | the impact of  conversion of preferred stock or exercise of warrants on the price of our  common stock;                                                                                                                      |
|   |                                                                                                                                                                                                                         |
| · | the ability of  our preferred stockholders and lenders to hinder additional financing; and                                                                                                                                   |
|   |                                                                                                                                                                                                                         |
| · | the influence  that our management and larger stockholders have over actions taken by the  company.                                                                                                                          |

 

If one or more of theseor other risks or uncertainties materialize, or if our underlying assumptionsprove to be incorrect, actual results may vary significantly from what weprojected. These forward-looking statements and other statements made elsewherein this report are made in reliance on the Private Securities Litigation ReformAct of 1995.  Any forward-lookingstatement you read in this Quarterly Report on Form 10-Q or our AnnualReport on Form 10-K reflects our current views with respect to futureevents and is subject to these and other risks, uncertainties and assumptionsrelating to our operations, results of operations, growth strategy andliquidity. We assume no obligation to publicly update or revise theseforward-looking statements for any reason, or to update the reasons actualresults could differ materially from those anticipated in these forward-lookingstatements, even if new information becomes available in the future.  The section below entitled “Factors That May AffectFuture Results of Operations” sets forth and incorporates by reference certainfactors that could cause actual future results of the Company to differmaterially from these statements.

 

Critical Accounting Policies and Estimates

 

Management’s discussion and analysis of financialcondition and results of operations are based upon our unaudited condensedconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities.  On anon-going basis, we evaluate our estimates, including those related to productreturns, bad debts, inventories, income taxes, warranty obligations,restructuring, maintenance contracts and contingencies.  We base our estimates on historicalexperience and on various 

 

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other assumptions that we believe are reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources.  Actualresults may differ from these estimates under different assumptions orconditions.

 

We believe the following critical accounting policiesaffect our more significant judgments and estimates used in the preparation ofour unaudited condensed consolidated financial statements.

 

*Revenue Recognition*

 

Wegenerally recognize product revenue upon shipment or delivery of product.Product revenue includes TraceCop sales of data bases and data base updates.  We accrue for estimated warranty costs andsales returns at the time of shipment based on our experience. Revenue frommaintenance contracts is deferred and recognized over the contractual periodthe services are performed, generally one year. There is a risk that technical issues on new products could result inunexpected warranty costs and returns. However, as we migrate to more of a software-based business model, thewarranty costs should continue to decline. To the extent that they do decline, our warranty reserve from currentsales will decrease.  To the extent thatour warranty costs exceed our expectations, we will increase our warrantyreserve to compensate for the additional expense expected to be incurred.  We review these estimates periodically anddetermine the appropriate reserve percentage. However, to date, warranty costs and sales returns have not beenmaterial.  Historically, our estimatesfor these items have not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

 

Aninsignificant portion of our revenue is related to licensing of our softwareproducts.  We recognize this revenue inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition”, SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” and Staff Accounting Bulletin (“SAB”) No. 104,“Revenue Recognition.  We defer andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

 

Wegenerally recognize service revenue upon delivery of the contractedservice.  Service revenue, primarilyincluding maintenance, training and installation, are recognized upon deliveryof the service and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

Cashcollected in advance of product delivery or services being provided aredeferred and recognized when all other revenue recognition criteria are met.

 

*Allowance for Doubtful Accounts and Returns*

 

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. Our receivables areuncollaterized and we expect to continue this policy in the future.  If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

 

*Inventory*

 

Wewrite down our inventory for estimated obsolescence or unmarketable inventoryequal to the difference between the cost of inventory and the estimated marketvalue based upon assumptions about future demand and market conditions. Ifactual market conditions are less favorable than those projected by management,additional inventory write-downs may be required.   Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

 

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Results of Operations

 

The following table sets forth, for the periodsindicated, certain financial data as a percentage of net revenues. Theperiod-to-period comparison of financial results is not necessarily indicativeof future results.

 
| ** **                                       | ** ** | **Three Months Ended**  | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **March 31, 2009** | ** ** | **March 31, 2008** | ** ** |
| Net product revenue                              |       | 88.9                    | %          | 64.7 | % |
| Net customer support and maintenance revenue     |       | 11.1                    |       | 35.3 |   |
| Total revenue                                    |       | 100.0                   |       | 100.0 |   |
| Cost of product revenue                          |       | 31.7                    |       | 37.6 |   |
| Cost of customer support and maintenance revenue |       | 0.6                     |       | 1.2 |   |
| Total cost of revenue                            |       | 32.3                    |       | 38.8 |   |
| Gross profit                                     |       | 67.7                    |       | 61.2 |   |
| Operating expenses:                              |       |                    |       |   |   |
| Sales and marketing                              |       | 30.9                    |       | 80.3 |   |
| Research and development                         |       | 42.8                    |       | 111.5 |   |
| General and administrative                       |       | 30.3                    |       | 57.4 |   |
|                                             |       |                    |       |   |   |
| Operating loss                                   |       | (36.3                   | )          | (188.0 | ) |
|                                             |       |                    |       |   |   |
| Interest expense, net                            |       | (1.3                    | )          | (1.2 | ) |
| Loss before income tax provision                 |       | (37.6                   | )          | (189.2 | ) |
|                                             |       |                    |       |   |   |
| Income tax provision                             |       | —                  |       | — |   |
|                                             |       |                    |       |   |   |
| Net loss                                         |       | (37.6                   | )%         | (189.2 | )% |
| Preferred stock dividends accrued                |       | (4.6                    | )          | (8.7 | ) |
|                                             |       |                    |       |   |   |
| Net loss attributable to common stockholders     |       | (42.2                   | )%         | (197.9 | )% |

 
| ** **          | ** ** | **Three Months Ended**  | ** ** |
|---------------------|------------|-------------------------|------------|
| ** **          | ** ** | **March 31, 2009** | ** ** | **March 31, 2008** | ** ** |
| Domestic revenues   |       | 96.9                    | %          | 84.6 | % |
| Export revenues to: |       |                    |       |   |   |
| Europe              |       | 2.8                     |       | 14.0 |   |
| Canada              |       | 0.0                     |       | 0.1 |   |
| Asia                |       | 0.1                     |       | 0.9 |   |
| Latin America       |       | 0.2                     |       | 0.4 |   |
|                |       |                    |       |   |   |
| Net revenues        |       | 100.0                   | %          | 100.0 | % |

 

**Net Revenues**.  Net revenuesfor the quarter ended March 31, 2009 were $0.9 million, compared to $0.5million for the same period in 2008. Product revenues increased $0.5 million for the quarter ended March 31, 2009, compared to thesame period in 2008.  Increased productrevenues are due to an increase in sales of our TraceCop product line.  TraceCop revenues were $0.8 million for thequarter ended March 31, 2009, compared to $0.3 million for the samequarter in 2008.  Substantially all ofour revenue for the quarters ended March 31, 2009 and 2008 were derivedfrom TraceCop sales.  Customer supportand maintenance revenue decreased $68 thousand for the quarter ended March 31,2009 compared to the same period in 2008. This decrease was due to the current sales mix with a high concentrationof government sales not requiring a maintenance contract.

 

**Concentration of Revenues**. Revenues from sales to various U.S. government entities totaled $0.8million, or 89.3% of revenues, for the quarter ended March 31, 2009compared to $0.3 million, or 59.6% of revenues, for the same period in2008.  Although we expect ourconcentration of revenues to vary among customers in future periods dependingupon the timing of certain sales, we anticipate that sales to governmentcustomers will continue to account for a significant portion of our revenues infuture periods.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customerswhich could adversely affect our revenues, including, without limitation,potential disruption to appropriation and spending patterns and the government’sreservation of the right to cancel contracts and purchase orders for itsconvenience.  Although we do notanticipate that any of our 

 

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revenues with government customers will berenegotiated, a large number of cancelled or renegotiated government orderscould have a material adverse effect on our financial results.  Currently, we are not aware of any proposedcancellation or renegotiation of any of our existing arrangements withgovernment entities and, historically, government entities have not cancelledor renegotiated orders which had a material adverse effect on our business.

 

**Gross Profit**.  Gross profitwas $0.6 million or 67.7% of net revenues for the quarter ended March 31,2009, compared to $0.3 million or 61.2% of net revenues for the quarter ended March 31,2008.  Gross profit on product revenuesfor the quarter ended March 31, 2009, trended to 64.4% from 41.8% for thequarter ended March 31, 2008 mainly due to an increase in net revenuesand/or decreases in fixed costs.  Grossprofit on customer support and maintenance revenues for the quarter ended March 31,2009, trended to 94.5% from 96.6% for the quarter ended March 31,2008.  Gross profit as a percentage of net revenues isimpacted by several factors, including shifts in product mix, changes inchannels of distribution, revenue volume and pricing strategies.

 

**Sales and Marketing**.  Sales andmarketing expenses decreased to $0.3 million for the quarter ended March 31,2009, compared to $0.4 million for the quarter ended March 31, 2008,primarily due to a planned reduction in sales and marketing personnel andrelated expenses.  Sales and marketingexpenses may vary in the future. However, we believe that these costs will remain relatively constantthrough the end of 2009, although expenses may be increased if we achieveincreases in revenue.

 

**Research and Development**.  Research anddevelopment expenses decreased to $0.4 million for the quarter ended March 31,2009 compared to $0.5 million for the quarter ended March 31, 2008.  Research and development costs are expensedin the period incurred.  Research anddevelopment expenses decreased in the three months ended March 31, 2009,compared to the same periods in 2008 primarily due to shifts from research anddevelopment expenses to cost of sales in relation to engineering contractjobs.  Research and development expensesmay vary in the future; however, we believe that these costs will remainrelatively constant through the end of 2009, although expenses may be increasedif we achieve increases in revenue.

 

**General and Administrative**.  General andadministrative expenses remained constant at $0.3 million for the quarter endedMarch 31, 2009 compared to $0.3 million for the quarter ended March 31,2008.  It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of 2009, although expenses may be increased if we achieve increasesin revenue.

 

**Interest**.  Net interestexpense increased to $12 thousand for the quarter ended March 31, 2009compared to $6 thousand interest expense for the same period in 2008.  The increase in interest expense wasprimarily due to an increase in interest expenses related to borrowings from aloan payable to an officer and penalty interest expense accrued for preferredshareholders.  Net interest expense mayvary in the future based on our level of borrowing, which will be affected byour cash flow, operating income and capital expenditures.

 

Liquidity and Capital Resources

 

Our principal source of liquidity at March 31,2009 is approximately $ 174 thousand of cash and cash equivalents.  At March 31, 2009, we had a workingcapital deficiency of $1.65 million compared to a $1.3 million deficiency at March 31,2008.

 

Cash used in operations forthe three months ended March 31, 2009 was $0.5 million, primarily due to anet loss of $322 thousand, a decrease in deferred revenue of $340 thousand, adecrease in accounts payable and accrued expenses of $42 thousand, and anincrease in prepaid expenses and other assets of $5 thousand.  This cash decrease was partially offset bydepreciation expense of $17 thousand, stock-based compensation of $17 thousand,a decrease in accounts receivable of $141 thousand, and a decrease ininventories of $4 thousand.  Cash used inoperations for the three months ended March 31, 2008 was $0.9 million,primarily due to a net loss of $0.9 million, an increase in accounts receivableof $53 thousand and a decrease in accounts payable and accrued expenses of $33thousand.  This cash decrease waspartially offset by depreciation expense of $12 thousand, stock-basedcompensation of $5 thousand, a decrease in inventories of $24 thousand, adecrease in prepaid expenses and other assets of $11 thousand, and an increasein deferred revenue of $21 thousand.  Future fluctuations in inventory balances, accounts receivable andaccounts payable will be dependent upon several factors, including, but notlimited to, quarterly sales, our strategy in building inventory in advance ofreceiving orders from customers, and the accuracy of our forecasts of productdemand and component requirements.

 

Cash provided by financing activities in the threemonths ended March 31, 2009 was $150 thousand, primarily consisting of theproceeds from a promissory note from our Chief Executive Officer, G. WardPaxton, compared to cash provided by financing activities in the three monthsended March 31, 2008 of $0.6 million, primarily consisting of the proceedsfrom the issuance of a promissory note for $0.7 million and payments on theline of credit of $86 thousand.

 

At March 31, 2009,the Company did not have any material commitments for capital expenditures.

 

During the three monthsended March 31, 2009, the Company funded its operations through the use ofcash and cash equivalents, and borrowings of $150 thousand from our CEO, G.Ward Paxton.

 

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On March 29, 2006,we entered into a Loan and Security Agreement (the “Loan Agreement”) withSilicon Valley Bank (“SVB”) to establish a $1.0 million line of credit with SVB(the “2006 Credit Line”).  On June 30,2008, we entered into an Amended and Restated Loan and Security Agreement (the “Amendedand Restated Loan Agreement”) with SVB to, among other things, replace the 2006Credit Line with a new $2.5 million line of credit (the “Current Line of Credit”).  Our obligations under the Amended andRestated Loan Agreement are secured by substantially all of our assets,including all of our intellectual property. Borrowings under the Current Line of Credit are based on advances (each,an “Advance”) against certain of our accounts receivable that are approved bySVB (each an “Eligible Account”).  SVBmay make an Advance of up to eighty percent (80%) of each Eligible Account, orsuch other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance chargecalculated as a daily rate that is based on a 360-day annual rate of (a) thegreater of the prime rate or 5.25%, plus (b) 1.5% or 2.0%, depending oncertain qualifying financial factors specified in the Amended and Restated LoanAgreement.  Finance charges are payableat the same time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.25% or 0.5% of all outstanding Advances, depending on certain qualifyingfinancial factors specified in the Amended and Restated Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Amended and Restated LoanAgreement, or (c) the date on which any “Adjustment” (as defined in theAmended and Restated Loan Agreement) is asserted to the Eligible Account.  On June 29, 2009, the Amended andRestated Loan Agreement terminates and all outstanding advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsbecome due under the Amended and Restated Loan Agreement and relateddocuments.  We have certain non-financialand financial covenants, including a liquidity coverage ratio and a rollingEBITDA computation, as defined in the Loan Agreement.  We have no borrowings outstanding under theCurrent Line of Credit as of March 31, 2009 and had borrowings availableof $18 thousand.

 

Asof March 31, 2009, we had cash and cash equivalents of approximately$174,000, down from approximately $554,000 as of December 31, 2008 and aworking capital deficit totaling $1.65 million. We used $530,000 of cash in operations in the first quarter 2009 andoperating cash outflows may continue in 2009. If we were required to redeem all shares of our Series 2 preferredStock and Series 3 Preferred Stock, the aggregate redemption price wouldbe approximately $2.1 million.  As of March 31,2009, in addition to cash and cash equivalents of $174,000, we had $18 thousandin funding available under our $2.5 million line of credit at Silicon ValleyBank, $70,000 available borrowings on our note from G. Ward Paxton, the Company’s Chairman, President andChief Executive Officer, and $1.5 million funding available from a writtencommitment to investup to $1.5 million from G. Ward Paxton.  Based onprojections of growth in revenue and net income in the coming quarters, and theborrowings available previously mentioned, we believe that we will have  sufficient cash resources to finance ouroperations and expected capital expenditures for the next twelve months. We expect to fund our operations through Company profits, our line ofcredit, borrowings from the Company’s CEO, and possibly additional investmentsof private equity and debt, which, if we are able to obtain, will have theeffect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

We may explore the possible acquisitions ofbusinesses, products and technologies that are complementary to our existingbusiness.  We are continuing to identifyand prioritize additional security technologies, which we may wish to develop,either internally or through the licensing, or acquisition of products fromthird parties.  While we may engage fromtime to time in discussions with respect to potential acquisitions, there canbe no assurances that any such acquisitions will be made or that we will be ableto successfully integrate any acquired business.  In order to finance such acquisitions andworking capital it may be necessary for us to raise additional funds throughpublic or private financings.  Any equityor debt financings, if available at all, may be on terms, which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders.

 

Item 4T.                        CONTROLS AND PROCEDURES

 

We maintain “disclosurecontrols and procedures,” as defined in Rule 13a-15(f) under the ExchangeAct, that are designed to ensure that information required to be disclosed byus in reports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our principal executive officer and principal financialofficer, as appropriate, to allow timely decisions regarding requireddisclosure.  In designing and evaluatingour disclosure controls and procedures, management recognized that disclosurecontrols and procedures, no matter how well conceived and operated, can provideonly reasonable assurance of achieving the desired control objectives, and wenecessarily are required to apply our judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures.

 

Our management, includingour principal executive officer and principal financial officer, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of March 31, 2009 and concluded that the disclosure controlsand procedures were effective.

 

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There have not been anychanges in our internal control over financial reporting that occurred duringthe quarter ended March 31, 2009 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II– OTHER INFORMATION**

 

Item 1.                             LEGAL PROCEEDINGS

 

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows.  However, there can be noassurance such legal proceedings will not have a material impact.

 

Item 1A.      RISK FACTORS

 

**Factors That May Affect Future Results of Operations**

 

Weare providing the following information regarding changes that have occurred topreviously disclosed risk factors from our Annual Report on Form 10-K forthe year ended December 31, 2008. In addition to the other information set forth below and elsewhere inthis report, you should consider the factors discussed under the heading “FactorsThat May Affect Future Results of Operations” in our Form 10-K forthe year ended December 31, 2008. The risks described in our Quarterly Reports on Form 10-Q are notthe only risks facing our Company. Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect our business,financial condition and/or operating results.

 

***Ourcash, cash equivalents, and investments decreased from $554 thousand at December 31,2008 to $ 176 thousand at March 31, 2009. If net cash outflows continue, we may not have sufficient cash tooperate our business and may not be able to maintain certain liquidityrequirements.  Additional debt and equityofferings to fund future operations may not be available and, if available, maysignificantly dilute the value of our currently outstanding common stock.***

 

Asof March 31, 2009, we had cash and cash equivalents of approximately$174,000, down from approximately $554,000 as of December 31, 2008 and aworking capital deficit totaling $1.65 million. We used $530,000 of cash in operations in the first quarter 2009 andoperating cash outflows may continue in 2009. As of March 31, 2009, in addition to cash and cash equivalents of$174,000, we had $18 thousand in funding available under our $2.5 million lineof credit at Silicon Valley Bank, $70,000 available borrowings on our note fromG. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer, and $1.5million funding available from a written commitment to invest up to $1.5 million from G. WardPaxton.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have  sufficient cash resources to finance ouroperations and expected capital expenditures for the next twelve months. We expect to fund our operations through Company profits, our line ofcredit, borrowings from the Company’s CEO, and possibly additional investmentsof private equity and debt, which, if we are able to obtain, will have theeffect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

***Wehad a net loss of $0.3 million for the quarter ended March 31, 2009 andhave an accumulated deficit of $58.6 million as of March 31, 2009.  To achieve profitability, we must continue togenerate greater revenue levels.***

 

For the quarter ended March 31,2009, we incurred a net loss of $0.3 million and had an accumulated deficit ofapproximately $58.6 million as of March 31, 2009, compared to a net lossof $0.9 million and an accumulated deficit of approximately $58.3 million as ofMarch 31, 2008. ** **We need to generate and sustainsubstantially greater revenues from the sales of our products if we are toachieve profitability.  If we are unableto achieve these greater revenues, our losses will continue for the near termand possibly longer, and we may never achieve or sustain profitability orgenerate positive cash flow from operations.

 

***Ifour newer products do not achieve market acceptance, our revenues may decline.***

 

Our new entityidentification products, regulated information compliance systems and networksecurity products have only been in the market place for a limited period oftime and may have longer sales cycles than our previous products.  Accordingly, we may not achieve themeaningful revenue growth needed to sustain operations.  We can provide no assurances that sales ofour newer products will continue to grow or generate sufficient revenues tosustain our business.  If we are unableto recognize revenues due to longer sales cycles or other problems, our resultsof operations will be adversely affected, perhaps materially.

 

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We have not yet receivedbroad market acceptance for our newer products. We cannot assure you that our present or future products will achievemarket acceptance on a sustained basis. In order to achieve market acceptance and achieve future revenue growth,we must introduce complementary security products, incorporate new technologiesinto our existing product lines and design, develop and successfullycommercialize higher performance products in a timely manner.  We cannot assure you that we will be able tooffer new or complementary products that gain market acceptance quickly enoughto avoid decreased revenues during current or future product introductions ortransitions.

 

***A large percentage of our revenues are received from U.S.government entities, and the loss of one of these customers could reduce ourrevenues and materially harm our business and prospects.***

 

A large percentage of ourrevenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the quarter ended March 31,2009, sales to U.S. government entities collectively accounted for 89.3% of ourrevenues, compared to 59.6% of our revenues as of March 31, 2008.  The loss of any of these key relationshipsmay send a negative message to other U.S. government entities ornon-governmental customers concerning our product offering. We cannot assure you that U.S. government entities will be customersof ours in future periods or that we will be able to diversify our customerportfolio to adequately mitigate the risk of loss of any of these customers.

 

***Government customers involve unique risks, which couldadversely impact our revenues.***

 

We expect to continue toderive a substantial portion of our revenues from U.S. government customers inthe future.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customers,including potential disruption due to appropriation and spending patterns,delays in approving a federal budget and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding,qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulationswith which we must comply and which can vary significantly amongdepartments.  As a result, cutbacks orre-allocations in the federal budget or losses of government sales due to otherfactors could have a material adverse effect on our revenues and operatingresults.

 

***Weare highly dependent on sales made through indirect channels, the loss of whichwould materially adversely affect our operations.***

 

We derived 43.9% ofrevenue in the first quarter of 2009 through indirect channels of mainly governmentresellers, compared to 16.2% of our revenues as of March 31, 2008.   We must expand our sales through theseindirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, which couldresult in lower prices and reduced profit margins for sales of our products.

 

***The payment of accrued dividends on our preferred stock maystrain our cash resources.***

 

On March 25,2004, we completed a $5,000,000 private placement pursuant to which we issued1,000,000 shares of our 5% Convertible Preferred Stock (the “Series 1Preferred Stock”) and warrants to acquire 556,619 shares of our commonstock.  The conversion price for the Series 1Preferred Stock and the exercise price of the warrants is $3.144 pershare.  As of April 30, 2009, therewere 259,696 shares of the Series 1 Preferred Stock outstanding,representing approximately 413,003 shares of common stock upon conversion.

 

On March 28,2005, we completed a $2,663,000 private placement pursuant to which we issued1,065,200 shares of our Series 2 5% Convertible Preferred Stock (the “Series 2Preferred Stock”) and warrants to acquire 532,600 shares of our commonstock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of April 30,2009, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion.

 

OnDecember 2, 2005, we completed a $1,230,843 private placement pursuant towhich we issued 564,607 shares of our Series 3 5% Preferred Stock (the “Series 3Preferred Stock”) and warrants to acquire 282,306 shares of our commonstock.  The preferred shares may beconverted into 564,607 shares of common stock at an initial conversion price of$2.18 per share, and the warrants may be exercised at a price of $0.40 pershare during the five-year period commencing on June 2, 2006.  As of April 30, 2009, there were 354,056shares of Series 3 Preferred Stock outstanding, representing 354,056shares of common stock upon conversion.

 

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***Wehave been unable to pay scheduled dividends on shares of our preferred stock,and the continued failure to make such payments has resulted in late penaltypayments and could potentially result in additional consequences, some of themmaterial.***

 

During the quarterended March 31, 2009, we accrued $16,000 in dividends to the holders ofour 5% Preferred Stock, $14,000 in dividends to the holders of our Series 25% Preferred Stock and $10,000 in dividends to the holders of our Series 35% Preferred Stock.  At March 31,2009, we have dividends accrued of $97,000 related to our 5% Preferred Stock,$81,000 related to our Series 2 5% Preferred Stock and $56,000 related toour Series 3 5% Preferred Stock. Delaware law provides that we may only pay dividends out of our capitalsurplus or, if no surplus is available, out of our net profits for the fiscalyear the dividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years and as of the quarter ended March 31, 2009, did not havesufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  We cannotassure you that our net assets will exceed our stated capital or that we willhave net profits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  Because we were unableto pay dividends on our preferred stock, we began accruing an additional latefee penalty of 18% per annum on the unpaid dividends for the Series 2Preferred Stock and Series 3 Preferred Stock.  Our CEO and outside board member that areinvested in Series 2 and Series 3 Preferred Stock have waived thelate fee penalty.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates of designation.  If we were required to redeem all shares of Series 2Preferred Stock and Series 3 Preferred Stock as of April 30, 2009,the aggregate redemption price we would owe would be $2.1 million.

 

***Youwill experience substantial dilution upon the conversion or redemption of theshares of preferred stock and the exercise of warrants that we issued in ourrecent private placements or in the event we raise additional funds through theissuance of new shares of our common stock or securities convertible or exercisableinto shares of common stock.***

 

On April 30,2009, we had 11,638,405 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have13,768,291 shares of common stock outstanding, approximately a 25.0% increasein the number of shares of our common stock outstanding.

 

Further, the occurrenceof certain events could entitle holders of our Series 2 Preferred Stockand Series 3 Preferred Stock to require us to redeem their shares for acertain number of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amountsto the holders, (ii) incurred accrued but unpaid dividends on April 30,2009 of $137,000, (iii) a volume weighted average price of $0.23, whichwas the ten-day volume weighted average closing price of our common stock on April 30,2009, and (iv) our 11,638,405 shares of common stock outstanding on April 30,2009, upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 15,295,042 shares of our common stock.  This would represent an increase ofapproximately 131% in the number of shares of our common stock as of April 30,2009.

 

In addition, managementmay issue additional shares of common stock or securities exercisable orconvertible into shares of common stock in order to finance our continuingoperations.  Any future issuances of suchsecurities would have additional dilutive effects on the existing holders ofour Common Stock.

 

***Theconversion of preferred stock or exercise of warrants we issued in the privateplacements may cause the price of our common stock to decline.***

 

The holders of the sharesof our 5% Preferred Stock and warrants we issued in connection with the sale ofour 5% Preferred Stock may freely convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock pursuantto Rule 144 of the Securities and Exchange Commission.  As of April 30, 2009, 740,304 shares ofour 5% Preferred Stock had converted into 1,177,327 shares of common stock.

 

The holders of the sharesof Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 Preferred Stock may freely convert their sharesof preferred stock and exercise their warrants and sell the underlying sharesof common stock pursuant to Rule 144 of the Securities and ExchangeCommission.  As of April 30, 2009,605,200 shares of Series 2 Preferred Stock had converted into 605,200shares of common stock.

 

The holders of the sharesof Series 3 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 3 Preferred Stock, may freely convert their sharesof Series 3 Preferred Stock and exercise their warrants and sell theunderlying shares of common stock pursuant to Rule 144 of the Securitiesand Exchange Commission.  As of April 30,2009, 210,551 shares of Series 3 Preferred Stock had converted into210,551 shares of common stock.

 

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For the four weeks endedon April 30, 2009, the average daily trading volume of our common stock onThe OTCBB was 869 shares.  Consequently,if holders of preferred stock or warrants elect to convert their remainingshares or exercise their warrants and sell a material amount of theirunderlying shares of common stock on the open market, the increase in sellingactivity could cause a decline in the market price of our common stock.  Furthermore, these sales, or the potentialfor these sales, could encourage short sales, causing additional downwardpressure on the market price of our common stock.

 

***Certainrights of the holders of our preferred stock and the terms of our securedcredit line may hinder our ability to raise additional financing.***

 

Under the terms ofour preferred stock instruments, we cannot issue shares of capital stock withrights senior to those of our existing 5% Preferred Stock, Series 2 5%Preferred Stock or Series 3 5% Preferred Stock without the approval of atleast a majority of the holders of our 5% Preferred Stock, all of the holdersof our Series 2 5% Preferred Stock, and holders of at least 75% of our Series 35% Preferred Stock voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of each class of ourPreferred Stock.  Furthermore, the termsof our secured credit line with Silicon Valley Bank include covenants whichrestrict our ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

 

***Our management and larger stockholders exercise significantcontrol over our company and have the ability to approve or take actions thatmay be adverse to your interests.***

 

As of April 30,2009, our executive officers, directors and preferred stockholders beneficiallyown approximately 39% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, we contemplate the possible issuanceof shares of our Common Stock or of securities exercisable or convertible intoshares of our Common Stock in the future by our Chief Executive Officer.  Any such issuance will increase thepercentage of stock our Chief Executive Officer and our management groupbeneficially holds.

 

Item 3.                                Defaults Upon Senior Securities

 

During the quarterended March 31, 2009, we accrued 16,000 in dividends to the holders of our5% Preferred Stock, $14,000 in dividends to the holders of our Series 2 5%Preferred Stock and $10,000 in dividends to the holders of our Series 3 5%Preferred Stock.  At March 31, 2009,we have dividends accrued of $97,000 related to our 5% Preferred Stock, $81,000related to our Series 2 5% Preferred Stock and $56,000 related to our Series 35% Preferred Stock.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and as of thequarter ended March 31, 2009, did not have sufficient capital surplus,defined as the amount by which our net assets exceed our stated capital, basedon par value of our outstanding shares as provided by Delaware law.  We cannot assure you that our net assets willexceed our stated capital or that we will have net profits in order to paythese dividends in the future.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  Our CEO and outsideboard member that are invested in Series 2 and Series 3 PreferredStock have waived the late fee penalty. In addition to this late penalty, the holders of our Series 2Preferred Stock and Series 3 Preferred Stock could elect to present uswith written notice of our failure to pay dividends as scheduled, in which casewe would have 45 days to cure such a breach. In the event that we failed to cure the breach, the holders of theseshares of preferred stock would then have the right to require us to redeemtheir shares of preferred stock for a cash amount calculated in accordance withtheir respective certificates of designation. If we were required to redeem all shares of Series 2 PreferredStock and Series 3 Preferred Stock as of April 30, 2009, theaggregate redemption price we would owe would be $2.1 million.

 

Item 6.                                Exhibits

 

The following Exhibitsare filed with this report form 10-Q:

 
| 31.1 |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                  |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                  |
| 32.1 |   | Certification Pursuant to Rule 13a-14(b) of  the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

 
| ** **              | **INTRUSION INC.**                                                       |
|-------------------------|--------------------------------------------------------------------------|
|                    |                                                                     |
| Date: May 14, 2009 | /s/ G. Ward Paxton                                                       |
|                    | G. Ward Paxton                                                           |
|                    | Chairman, President & Chief Executive  Officer                  |
|                    | (Principal Executive Officer)                                            |
|                    |                                                                     |
|                    |                                                                     |
| Date: May 14, 2009 | /s/ Michael L. Paxton                                                    |
|                    | Michael L. Paxton                                                        |
|                    | Vice President, Chief Financial Officer,  Treasurer & Secretary |
|                    | (Principal Financial & Accounting Officer)                      |

 

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